Financial Statement Analysis And The Valuation Of Common Stock Chapter 16 Financial Statement Analysis And The Valuation Of Common Stock Mark Higgins

Valuing a Corporation Expected present value is one widely accepted method of valuing a company. This was discussed in detail in Chapter 6. This method requires two inputs: Estimates of future cash flow Estimates of appropriate interest rates

Framework for Constructing Financial Statements Projected cash flow from operations Projected cash flow from investing Organization (Entity)

Projection of Cash Flows minus equals Projected cash flow from operations Projected cash flow from investing Projected net cash flows to input valuation model

Projected Cash Flows From Operations Projected cash flows from operations is a function of: Sales projections Expense projections Working capital projections

Type of Information Needed To Project Cash Flows from Operations Strategic analysis of markets, competitors Sales projections Business model of how expenses are related to sales Expense projections Business model of how required investments in working capital are related to sales Working capital projections

Type of Information Needed To Project Cash Flows from Investing The information needed to project cash flows from investing is derived from a business model of how required capital investments are related to sales.

Time Series Benchmarks Time Series Benchmarks - The comparison of a company against itself through time. A benchmark is a comparison point against which an item is judged.

Examples of Time Series Benchmarks The following ratios serve as good benchmarks for evaluating a company over a period of time. Current Ratio Quick Ratio Debt to Equity Ratio Long-Term Debt to Equity

A Liquidity Ratio Current Ratio - Measures the companies short-term ability to pay its obligations Current Ratio = Current Assets Current Liabilities 32

A Liquidity Ratio Quick Ratio: Quick Ratio – A more conservative measure of a companies short-term ability to pay its obligations Quick Ratio: Cash, Marketable Securities, Receivables Current Liabilities 32

A Solvency Ratio Debt to Equity Ratio - measures the relationship of creditors claims to the assets to the shareholder’s claims to the assets. Total debt includes both current and long-term liabilities. Total Debt to Total Equity: Total Debt Total Shareholders Equity 33

A Solvency Ratio Long-Term Debt to Equity Ratio - measures the relationship of creditors long-term claims to the assets to the shareholder’s claims to the assets. Debt only includes long-term obligations. Total Debt to Total Equity: Total Debt Total Shareholders Equity 33

Cross Sectional Analysis A comparison of a companies financial statements to others in the industry is referred to as a cross-sectional analysis. This analysis is typically done using either the balance sheet or the income statement. To conduct this analysis, Standard Industrial Classification (SIC) codes are used. SIC codes put firms in groups using common characteristics for example, Landsend’s SIC code is 5961, “catalog/mail order houses”.

Cross Sectional Analysis Balance Sheet: To perform cross-sectional analysis on the companies balance sheet, each item is restated as a percentage of total assets. In addition, for a more detailed analysis each item in current assets also could be restated as a percentage of total current assets.

Example: Cross Sectional Analysis Rhody has total assets of $60 million of which Cash is $5 million and Accounts Receivable are $12 million and total current assets are $28 million. Restate these assets using cross-sectional analysis.

Example: Cross Sectional Analysis Rhody’s cash represents 8.3% ($5 million/$80 million) of its total assets while accounts receivable represents 20% ($12 million/$60 million) of it total assets. A detailed analysis of the total current assets reveals that cash represents 17.6% ($5 million/$28 million) of its current assets and accounts receivable represents 42.9% ($12 million/$28 million) of its current assets.

Example: Cross Sectional Analysis Rhody has total sales of $80 million of which cost of goods sold is $44 million and selling, general, and administrative expenses are $23 million. Restate these expenses using cross-sectional analysis.

Example: Cross Sectional Analysis Rhody’s cost of goods sold represents 55% ($44 million/$80 million) of its total sales while selling, general, and administrative expenses represents 28.8% ($23 million/$80 million) of it total assets. As with cross sectional analysis of the balance sheet, these items would be compared to other companies in the same industry.

Cross Sectional Analysis Income Statement: To perform cross-sectional analysis on a companies income statement, each item is is restated as a percentage of total sales.

Horizontal Analysis A comparison of a companies financial statements to itself over time. This analysis is typically done using either the balance sheet or the income statement. This analysis is done just like cross sectional analysis except it is an internal comparison of the company over time.

Articulation Articulation – is the linking of the balance sheet with the income statement. One method of linking these two financial statements is through turnover ratio. A simpler method is to treat all balance sheet items as a percentage of sales.

Articulation Articulation – is the linking of the balance sheet with the income statement. One method of linking these two financial statements is through turnover ratios (e.g. inventory turnover). A simpler method is to treat all balance sheet items as a percentage of sales (e.g., inventory as a percentage of sales.

Inventory Turnover Ratio PowerPoint Slides A companies inventory turnover is calculated as follows: Inventory Turnover Ratio: Cost of goods sold Average inventory Average Inventory = (Beginning Inv. + Ending Inv.)/2 35

Example: Inventory Turnover Assume that Rhody’s inventory turnover is 3.5 times and that its projected cost of goods sold for next year is $150 million its inventory at the beginning of the year was $36 million. What is Rhody’s ending inventory?

Example: Inventory Turnover Inventory Turnover Ratio: Cost of goods sold Average inventory 3.5 times = $150 million ($36 million + $X million) 3.5 (1/2 x 36 million + X) = 150 million X = (150 million/(3.5 x ½)) - 36 million X = 49.75 million

Free Cash Flow Free Cash Flow – is cash flow from operating activities minus cash flow for investing minus required increase in cash.

General Assumptions For Calculating Free Cash Flow Income Statement Sales growth Cost of sales as percentage of sales Operating expenses as percentage of sales Tax rate Balance Sheet Cash as percentage of sales Inventory as percentage of sales Other Current Assets Noncurrent assets as a percentage of sales Accounts payable as a percentage of sales Other current liabilities as a percentage of sales

Valuation In projecting the value of an entity the goal is to calculate free cash flow per year for each year in the projection period plus the present value of a perpetuity. The present value of a perpetuity is equal to the amount received divided by the interest rate.